Are Peer To Peer Loans Right For Your Portfolio?

Simon Moore
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Peer to peer (P2P) lending has taken off in recent years. Various fintech companies such as Lending Club, Prosper and Funding Circle and many more have shown that there's a business directly connecting those that are looking to borrow with individuals willing to lend. This is previously a business that was mostly operated by banks themselves lending their own money to their own customers. With peer to peer certain borrowers can potentially see lower interest payments and lenders may get a better return on their money than with other types of debt. Here I am discussing the lending side of peer to peer loans, so peer to peer as an investment strategy, rather than as a way to borrow.

Estimates vary, but the peer to peer market is expected to grow to somewhere between a few hundred billion to over trillion dollars over the coming years, as it captures a high single digit share of consumer lending. The key medium term questions for growth are firstly, how well banks react with their own online lending services, and secondly how successful peer to peer lenders are at maintaining effective lending standards.

So peer to peer lending appears innovative and fast-growing, but should you invest?

The Federal Reserve are keeping rates low, does peer to peer offer an opportunity?

Availability

Well, first, unfortunately, you may not be able to. Due to differing state regulation, peer-to-peer loans are available in the majority of states, but not everywhere, income qualifications may also apply, such as having an income of over $70,000. So unlike, for example, buying stocks on the stock market, peer to peer lending is not available to everyone. However, access is opening up as regulations evolve and lenders show broad track records. Currently, if you live in Iowa, New Mexico, North Carolina or Pennsylvania then your ability to own loans via peer to peer platforms is likely constrained, but in most other states in the US you may qualify. Certain states also essentially block borrowing on certain peer to peer platforms as well. This may open up over time.

Default Risk

The critical point with any sort of lending, and most longer term investments that involve economic risk, is that you should evaluate returns through the entire economic cycle. As Warren Buffet said, "Only when the tide goes out, do you discover who's been swimming naked." Often peer to peer debt is issued for several years and so earning a, say, 9% return in one year is great, but if the next year the loan defaults and you lose the full value only 1 year into a 3 year loan term, then that temporary 9% return is not so attractive. You've lost money. This is because debt investing even high single digit interest rates won't help you make money, if even 1 in 10 of the loans default. Of course, often peer to peer sites encourage you to diversify by owning a small piece of a large number of loans, and that can help make your returns more predictable, but how returns vary over time, particularly in recession, may be just as important.

This is a major point to understand with debt investing. Your upside is generally limited by the interest payment, so you do need to focus on the downside risk, which can be high. When a peer to peer loan defaults you may not receive anything back, as there typically no hard assets to backstop the loan. Even small rates of default can be a big hit to returns. These are a different set of risks and rewards to stocks.

Of course, like peer to peer loans, stocks can, and do, go bankrupt, causing investors to lose potentially their entire investment, but at the other end of the spectrum stocks can double or more, so the spread of risks are more balanced and some really big gains can help offset major losses. With debt investing, you do need to pay careful attention to your downside risk if you want to be successful, because your interest payments (your upside) can be fairly small relative to the total amount you have at risk (your downside).

The following chart shows charge off rates on credit card loans for large banks over time. This isn't a perfect match for peer to peer lending, as the type of lending and the standards behind it differ, but it does make the point that in a recession, things can look far worse for consumer lending than they do now. Currently default rates are around 4%, but historically recessions have seen far higher spikes.

The 2008 recession may be an extreme example relative to other recessions because it was a long, deep recession and many people were hit hard. There default rates exceeded 10%. Furthermore, recessions are, of course, hard to predict, but most economists would agree that the past few years have been reasonably positive and are a relatively good period in terms of outcomes for peer to peer lending. As such, though a recession may not be imminent, you should assume that not all years will see as low default rates for peer to peer than we're currently having.